Foreign Currency Arbitrage Explained

One of the concepts that can confuse people most and also lead to most excitement is a so-called financial arbitrage.

In circumstances where two exchange rates are really misaligned, then an opportunity could exist to actually use one currency to buy dollars, convert that to a second currency and then sell to get a profit - this process where you can make a guaranteed profit is called an arbitrage possibility.

Here is an example of how this could work just to explain the principle:

Imagine that the Dollar/pound rate is 2:1, which is not far off the actual rate at the time of writing.

Then let's also also say that the MySalary currency rate against sterling is 4:1 and that the MySalary / pound rate is 10:1.

We can now work out whether there is an arbitrage situation between these currencies and thus guaranteed profits there for any consumer who notices this fact.

Well, we now see that from these we can work out the cross rate and get that the Mysalary/Dollar rate is 5:1.

And now we see the opportunity by putting in any number: for instance if we begin with 4 MySalary units and conver to a $1, then convert the $1 to 50p and then convert that back into the MySalary currency then we get back 5 MySalary units - a profit of 1!

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